How Safe is Your Business Model From Disruption?

By Josh Blandy

What would it mean to your livelihood if the competitive position of your business disappeared seemingly overnight?

Add to that, a scenario where your newest and strongest competitors were able to enter your market for a significantly lower investment than the one you have made and, at the same time, are able to operate with far fewer fixed costs.

While you are thinking, consider a significant shift of power from you to your customers.

Congratulations! You are now the owner of a disrupted business model.

Disruption is not the same as competition.

If you ever studied economics you would likely have heard of something called ‘Perfect Competition’ which essentially states that the ability to make a profit is temporary at best. Once an opportunity in a market is identified, competitive pressures will reduce the price of the opportunity to equal the cost of its supply.

Now in the real world we know that this is not how things work. Many things work to protect your business from the threat of perfect competition. Things like geography, access to capital and labour, skills and experience, the size of your market, your existing market share, how much effort is required for your customers to switch to another provider, the list goes on…

However it is still getting harder to maintain a sustainable and value creating market position. According to Deloitte’s annual Shift Index report, focussed on long term economic trends:

In 2009 the Return on Assets for U.S. firms was less than 33% of what it was in 1965, (Return on Invested Capital followed a similar trend)

The rate at which a market leading business will lose its leadership position has more than doubled

“But that’s just the way competition works in the real world”, I hear you say, “Companies rise and fall all the time, I mean everyone knows that around 80 percent of businesses fail in the first five years”. But how much of this volatility is due to failure to scale or defend those barriers that work to protect your business from competition and how much is it due to their wholesale destruction?

Just ask people who used to invest and work in retail, offline directories, legal discovery, travel agencies, print media, television, recorded music, short term accommodation, publishing, telecommunications and soon taxi services, education, release based software licensing, SME IT services among others.

The barriers that protect your business from competition can also make it more vulnerable to disruption.

As my fluid dynamics lecturer said many years ago, “One man’s pump is another man’s blower” – technology and business model innovation in one industry can reveal opportunity in others that challenge even basic assumptions underpinning how things are ‘supposed to work’.

Let’s take a look at some of these protective barriers.

Market Size and Market Share: Market size and share is often quoted in units of currency, i.e. the market is worth $4 billion annually and if we can only get 5% market share we will have a $200 million dollar business. While this may be a convenient way of reporting it conceals their real drivers:

Market Size – the number of people or organisations who want the outcomes your business provides and how often they want them

Market Share – the number of customer transactions you can profitably acquire and retain

If your market size is restricted by geography then you are vulnerable to innovative distribution strategies of competitors who find a way around the geographic impasse.

Market size is also vulnerable to what I call ‘value proposition unbundling’. This is the situation where your product or service delivers multiple customer outcomes. However a material number of your customers may only value a subset of these outcomes and are not too fussed about the rest. All that is required to reduce your market size is for a competitor to discover this “hidden” segment and tailor offerings specifically for it. The impact of ‘budget’ / ‘low cost’ airlines on full service carriers is an example of value proposition unbundling.

Distribution: Distribution relates to the ‘where and when’ you can deliver your value propositions to customers. Distribution is usually:

Direct – where you physically interact with the customer

In-direct, where a third party interacts with the customer on your behalf

The more capital intensive your distribution channel is, the higher your fixed costs will typically be thereby requiring a larger volume of sales to sustain it. Unless your higher cost channel is a key differentiating value proposition you are vulnerable to competitors with lower cost channels, such as online or even franchisees / licensees, who are able to price lower than you.

Likewise, if you have a “Come To” distribution strategy, you will always be vulnerable to “Go To” distributors if your destination is not critical to the value proposition that is the real reason your customers buy from you. Just look at the impact of online “Go To” book sellers on “Come To” bricks and mortar shopfronts.

Your distribution strategy is also vulnerable to “Time Based Competition”. This is important when the speed of your distribution capability is highly valued by your customers. An example of disruptive time based competition is the negative impact of downloading on television ratings for “block buster” shows in geographies that, due to licensing decisions, are required to wait, in some cases for many months, for the show to air after its initial release.

Financial Barriers to Entry and Legacy Capital Structures: Access to capital was once, and in many industries still is, a barrier that must be conquered just to have the right to play. In many cases even the size of your addressable market is limited by the capacity you can afford to build into your business. Capacity can include production, (i.e. manufacturing), service delivery, (i.e. a consulting bench) and distribution, (i.e. number of “Come To” locations).

Advancements in other industries can enable new business models that can deliver high value outcomes your customers want for a much lower cost of entry. This means that these new competitors can achieve profitability and generate free cash flows with a materially lower pricing structure, significantly smaller sales volumes and far less capital at risk. A lower cost of entry can also reduce, or effectively eliminate, the capacity issues you have due to your legacy capital structure.

What would you do if, for example, your distribution capability was no longer limited by the seemingly high cost of geographic isolation?

“When I built my first company starting in 1999 it cost $2.5 million in infrastructure just to get started and another $2.5 million in team costs to code, launch, manage, market & sell our software”

These days, a start up can utilise a full, (and essentially free), open source software stack, rent virtualised infrastructure on demand from Amazon Web Services and contract skilled low cost developers from around the world via O Desk or Freelancer.com.

If someone could start a competitor to your business for 90% less than the investment you have had to make, what action would you take?

Value Propositions: Your value propositions are the reasons your customers buy from you. Now the funny thing about value propositions is that in many cases what you think your value propositions are differ from what your customers think they are both in terms of quality and quantity.

You should think of a value proposition as the promise you make to a customer to help them achieve a desired outcome, or as Clayton Christensen states, “get a job done”. Aside from a competitor doing the same thing you do, but only slightly better, you must monitor your value propositions for disruption from a number of different sources.

One source of disruption is when other protective barriers fail allowing already existing alternatives to more easily reach you customers. Changes in distribution capability, such ‘Time Based Competition’ mentioned above is an example. Material lowering of barriers to entry is another.

If your value proposition is based on price, how do you defend against lower cost producers?

Less visible sources of disruption include Value Proposition Unbundling described above, and Value Proposition Bridging.

Every business has a particular place within a value chain. Either your customers use what you supply as input to producing some other product or service or they consume it for themselves. Value Proposition Bridging occurs when the link your business holds in the value chain is ‘bridged’ by another product or service that simply eliminates the need for your link to exist in any meaningful way.

An example of Value Proposition Bridging can be seen in the legal industry where for at least ten years software has been steadily replacing the need for large numbers of human lawyers to undertake legal discovery work. In the book “Race Against the Machine”, Erik Brynjolfsson and Andrew McAfee from MIT, talk about how, “moving from human to digital labour during the [legal] discovery process could let one lawyer do the work of 500”. They go on to give the example of, Bill Herr, who as a lawyer at a major chemical company used to “muster auditoriums of lawyers to read documents for months on end”. Human lawyers, Bill found, were only 60% accurate compared to their faster and cheaper digital competitors.

Switching Costs: Switching costs are the effort and expenditure your customer must undertake to stop using you as a supplier and move to another. The higher the cost of switching, the less likely your customer is to leave. However the opposite is also true. The lower the effort is for a customer to switch to a new supplier, the less likely your customer is to stay with you once presented with a better value proposition.

Software As A Service (SaaS) providers leverage two key switching cost disrupting strategies to reduce effort required to invest in their service:

SaaS, in most cases, converts the capital that a business would previously invest in computing infrastructure and software licenses into a recurring operating cost

SaaS materially lowers the cost to a business to trial a new application or service. In many cases all you need is an internet connection and a web browser – no special equipment or complex IT upgrades required

Relying on switching costs to defend marginal value propositions is a temporary solution at best. Besides the fact that by doing so you are implicitly signalling that retention through threat of negative outcomes is good for your reputation, someone who values your customers more than you will find a way to reduce or eliminate that threat.

Again, in the Deloitte 2011 Shift Index, 68% of consumers agreed or strongly agreed they had significant access to data on brands and products. In addition, 68% of consumers agreed or strongly agreed that switching costs were minimal.

How safe is your business model?

How could a competitor make it easier for your customers to satisfy their needs than you currently do?

What would the value propositions of their product and service be?

How could they use new / emerging technologies to enter your market for significantly less than it cost you?

How could they use a different manufacturing process to produce your product at a higher quality for a lower cost?

How could they more effectively build relationships with your target customer segments and generate demand?

How would their relationships with your key customer segments differ to yours?

How would their supply chain differ and who would they partner with?

Would they utilise different channels for your customers to more easily obtain their product and service?

How would their day-to-day activities be different to yours?

Now it’s almost certain that you have an answer for one or more of the questions above and that’s great! You now have one or more opportunities to make your business model stronger and more profitable. If you can’t think of any, just ask your customers, they will definitely have some.

The real question is though, now that you know, what are you going to do about it?